Common-Value Auctions with Liquidity Needs: an Experimental

CommonValue Auctions with Liquidity Needs: An Experimental Test of a Troubled Assets Reverse Auction Lawrence M. Ausubel, Peter Cramton, Emel Filiz‐Ozbay, Nathaniel Higgins, Erkut Ozbay, and Andrew Stocking* 21 May 2009 Abstract We experimentally test alternative auction designs suitable for pricing and removing troubled assets from banks’ balance sheets as part of the financial rescue. Many individual securities or pools of securities are auctioned simultaneously. Securities that are widely held are purchased in auctions for individual securities. Securities with concentrated ownership are purchased as pools of related securities. Each bank has private information about its liquidity need and the true common value of each security. We study bidding behavior and performance of sealed‐ bid uniform‐price auctions and dynamic clock auctions. The clock and sealed‐bid auctions resulted in similar prices. However, the clock auctions resulted in substantially higher bank payoffs, since the dynamic auction enabled the banks to better manage their liquidity needs. The clock auctions also reduced bidder error. The experiments demonstrated the feasibility of quickly implementing simple and effective auction designs to help resolve the crisis. (JEL D44, C92, G01, G21. Keywords: financial crisis, uniform‐price auction, clock auction, market design, experiments, troubled assets, TARP.) 1 Introduction On 3 October 2008, the US Congress passed and the President signed the Emergency Economic Stabilization Act of 2008 (Public Law 110‐343). The Act established the $700 billion Troubled Asset Relief Program (TARP). It authorized the US Treasury to purchase troubled assets in order to restore liquidity to financial markets, favoring. the use of market mechanisms such as reverse auctions for asset purchases. An immediate question is what auction designs are well‐suited to the task. Ausubel and Cramton (2008a,b) discuss the design issues as they appeared in October 2008. This paper tests alternative auction designs in the economics laboratory. The test not only provides insights into bidding behavior and performance of the various designs, but it also demonstrates the feasibility of quickly implementing such auctions as part of a financial rescue. In terms of scope, the banks held roughly 8,000 distinct troubled securities, potentially available for purchase. For the purposes of this paper, these assets fall into two general groups: 1) those securities with ownership concentrated among only a few firms; and 2) those securities with less concentrated ownership. By the nature of these troubled assets, all are believed to be worth less than face value. However, some securities are more “troubled” than others. Some are relatively high‐valued * The authors are economics professors and doctoral candidates at the University of Maryland. Correspondence to: [email protected], [email protected], [email protected], [email protected], [email protected], and [email protected]. We thank Power Auctions LLC and its employees for customizing the auction software and making it available for this purpose. The views expressed are solely the opinions of the authors. securities (e.g., a market value of 75 cents on the dollar) and others are relatively low‐valued securities (e.g., a market value of 25 cents on the dollar). The challenge before the Treasury is to purchase these troubled assets so as to balance two competing criteria: 1) assuring that the taxpayer does not overpay for the assets; and 2) improving banking sector stability by purchasing assets from those banks most in need of liquidity. There is a rich economic literature that points to the advantages of a competitive process over negotiation (see e.g., Bulow and Klemperer 1996) and thus we focus exclusively on auctions for accomplishing Treasury’s objectives. It is within this context that we designed our auction experiment to help us understand the outcomes and relative advantages of alternative auction formats. During the period 12‐24 October 2008 and 6‐11 November 2008, using commercial auction software customized for our purpose, we tested two different auction environments at the University of Maryland’s experimental economics laboratory.1 For each auction environment, we analyzed sealed‐bid uniform‐price auctions and dynamic clock auctions, varying the level of competition, the information, and the banks’ need for liquidity. The experimental auction environments were closely tailored to the likely settings of the planned auctions for troubled assets. Specifically, to model the case where there is sufficient competition to conduct a competitive auction for individual securities, we ran an 8‐security simultaneous reverse auction. Each security has a pure common value with unconditional expectation of 50 cents on the dollar, bidders have private information about the common value, and a fixed quantity of each security is purchased in the same reverse auction. This is a security‐by‐security auction. In the second auction environment, the ownership of the security is too concentrated to allow individual purchase. Securities of a similar quality are pooled together, thus mitigating the concentration of ownership problem, and each security owner competes against others in the pool to sell securities to Treasury. In this second auction environment each security has a pure common value, bidders have asymmetric endowments, and bidders with larger holdings of a security have more private information about the common value. In order to implement an auction where dissimilar items are purchased together, bidders compete on the basis of a reference price, which reflects the government’s best estimate of the security’s value. Bidders then compete on a relative basis—a bid expresses willingness to tender a security at a stated percentage of the security's reference price. This is referred to as a reference price auction. The human subjects bidding in the auctions were experienced PhD students, highly motivated by the prospect of earning roughly $1200 each—the actual amount depending on performance—for participating in twelve experimental sessions, each lasting two to three hours, over the three‐week period. We chose to use experienced PhD students for these experiments, since the environment is considerably more complex than a typical economics experiment, and we believed that the PhD students’ behavior would be more representative of the sophisticated financial firms who would be participating in the actual auctions. Several conclusions emerge from the experiments. The auctions are competitive. Owing to the bidders’ liquidity needs, the Treasury pays less than the true common value of the securities under either format. The sealed‐bid auction is more prone to bidder error. The dynamic clock auction enables bidders to manage their liquidity needs better. The bidders attain higher payoffs (trading profits plus liquidity bonus) in the dynamic clock auctions than in the sealed‐bid auctions. 1 http://www.econ.umd.edu/resources/computing/experimental 2 Nevertheless, the clock auctions result in equivalent aggregate expenditures, so that the benefit to the bidders does not come at the taxpayers’ expense. The prices resulting from the clock auctions are a better indication of true values than those from the sealed‐bid auctions. Thus, the clock auction is apt to reduce risk for both banks and the Treasury, and to generate price information that may help to unfreeze the secondary markets. We conclude that the dynamic clock auction is beneficial for both the banks and the taxpayers. The banks attain higher payoffs than in the sealed‐bid auction, resulting from better liquidity management. The taxpayers are also better off, as the asset purchase program is better directed toward the liquidity needs of the banking sector without increasing the cost of the asset purchase program. The variability of outcomes is also reduced and the informativeness of prices is also increased with the clock format. More broadly, the experiments demonstrated the feasibility for quick implementation. The commercial auction platform was customized to handle both formats in one week. Both formats are easy to explain to bidders. Sophisticated subjects required only a three‐hour training session to understand the setting, the auction rules, and to practice using the software. In November 2008, the Treasury decided to concentrate on negotiated equity purchases and postpone the purchase of troubled assets via auction. In March 2009, the Treasury proposed auctions to purchase pools of legacy loans from banks’ balance sheets, but this time using a forward auction in which private investors compete to buy the pools of loans. Ausubel and Cramton (2009) describe the auction design issues in this new setting and argue for a two‐sided auction in which the private investors compete to buy loan pools in a forward auction, and then banks compete in a reverse auction to determine which trades transact. The results we present here are fully applicable to the new setting. The forward auction is analogous to the security‐by‐security auction, and the reverse auction is analogous to the reference price auction. The remainder of the paper proceeds as follows. In Section 2 we summarize the experimental literature with respect to dynamic and sealed‐bid auctions. Our analysis builds on this literature. Section 3 briefly describes the experimental setup. The instructions and related materials are available in the appendix. Section 4 provides

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